The Euro Area Is Coming to an End: Peter Boone and Simon Johnson

Nov. 28 (Bloomberg) -- Investors sent Europe’s politicians
a painful message last week when Germany had a seriously
disappointing government bond auction. It was unable to sell
more than a third of the benchmark 10-year bonds it had sought
to auction off on Nov. 23, and interest rates on 30-year German
debt rose from 2.61 percent to 2.83 percent. The message?
Germany is no longer a safe haven.

Since the global financial crisis of 2008, investors have
focused on credit risk and rewarded Germany with low interest
rates for its perceived frugality. But now markets will focus on
currency risk. Inflation will accelerate and the euro may break
up in a way that calls into question all euro-denominated
obligations. This is the beginning of the end for the euro zone.

Here’s why. Until 2008, investors assumed that all euro-zone sovereign bonds, as well as bank debt, were risk-free and
would never default. This made for a wonderfully profitable
trade: European banks could buy government debt, finance it at
less expensive rates through funding provided by the European
Central Bank, and pocket the spread.

Then credit conditions tightened around the world and some
flaws became evident. Greece had too much government borrowing;
Ireland had experienced a debt fueled real-estate bubble; and
even German banks had become highly leveraged. Investors
naturally decided some credit-risk premium was needed, so yields
started to rise.

Greece, Ireland, Portugal, Spain and now Italy have large
amounts of short term debt that they can’t roll over at low
cost. Leading European banks are in the same situation. None of
these countries or banks can long bear the burden of their
current debt levels at reasonable risk premiums.

Last Resort Technocrats

Many of Europe’s leading politicians, some International
Monetary Fund officials, and the technocrats-of-last-resort --
Mario Monti in Italy and Lucas Papademos in Greece -- mistakenly
believe that these risk premiums can be quickly reduced. They
argue that if they cut budget deficits, carry out structural
reforms and modestly recapitalize banks, their countries will
soon grow and regain access to markets.

More realistically, none of these countries will be
borrowing again soon in the capital markets. Ireland’s finance
minister, Michael Noonan, is at odds with reality when he claims
that Ireland should return to the markets in 2013. This is a
country with 133 percent of gross national product in public
debt and about 100 percent GNP in additional contingent
liabilities to the banking system. (We use gross national
product because gross domestic product is artificially raised by
the offshore profits of non-Irish multinational corporations,
most of which Ireland doesn’t tax.)

With such enormous debt burdens, even if the Irish or other
troubled countries manage to convince the market that there is
only a 5 percent to 10 percent annual risk of default, these
countries will experience high real interest rates -- plus
ensuing low investment and fragile banks -- for decades.

The French, along with U.S. and U.K. officials, are
pleading with the European Central Bank to come to the rescue.
Their hope is that the ECB can remove credit risk by promising
to back all sovereign and bank credits in the euro zone. This is
what politicians mean when they say “bring out the bazooka.”

When large amounts of any currency are printed in response
to deep structural flaws, it’s hard to trust that money. A
massive bond-purchase program by the ECB would reduce credit
risk but increase the danger that the euro will decline in value
against the dollar and other currencies. And if the ECB needs to
continue buying more debt to finance deficits and prevent
defaults -- because peripheral countries could stop making
painful fiscal adjustments once the ECB starts buying bonds --
wages and prices would increase, as we saw in the U.S. in the
1970s. This is anathema to the Germans.

Inflation Risk

We would soon see German bonds sold off as investors
protect themselves from long-term inflation, which erodes the
value of such debt. People holding bonds with a high credit risk
(such as Italy and Spain) would surely sell many of those to the
ECB, or simply cash out when those bonds mature in case the
central bank, at some point, stops buying.

An ECB “bazooka” wouldn’t restore competitiveness to
Europe’s periphery, so even with this, Europe’s troubled nations
would require many more years of tough austerity and budget
reform to stabilize debt.

This would all just look like another unsustainable debt
profile. Germany would be paying higher interest rates on its
debt, while most banks and the periphery would be heavily
financed by the ECB -- and both credit and currency risk
premiums would remain. Markets would eventually turn against
Europe with a vengeance, and with no more plausible solutions,
the whole system would come tumbling down amid both inflation
and debt restructuring.

Germany’s credit is impeccable, but the country is issuing
debt in a currency that is flawed and could soon be worth much
less than it is today. If Germany does block the “bazooka” and
instead takes on more of the fiscal burden in Europe -- for
example, through the obligations inherent in any kind of euro-bond issue -- this would reduce currency risk but undermine the
country’s credit rating.

The path of the euro zone is becoming clear. As conditions
in Europe worsen, there will be fewer euro-denominated assets
that investors can safely buy. Bank runs and large-scale capital
flight out of Europe are likely.

Devaluation can help growth but the associated inflation
hurts many people and the debt restructurings, if not handled
properly, could be immensely disruptive. Some nations will need
to leave the euro zone. There is no painless solution.

Ultimately, an integrated currency area may remain in
Europe, albeit with fewer countries and more fiscal
centralization. The Germans will force the weaker countries out
of the euro area or, more likely, Germany and some others will
leave the euro to form their own currency. The euro zone could
be expanded again later, but only after much deeper political,
economic and fiscal integration.

Tragedy awaits. European politicians are likely to stall
until markets force a chaotic end upon them. Let’s hope they are
planning quietly to keep disorder from turning into chaos.

(Peter Boone is a principal at Salute Capital Management, a
non-resident senior fellow at the Peterson Institute for
International Economics and a visiting senior fellow at the
London School of Economics. Simon Johnson, who served as chief
economist at the International Monetary Fund in 2007 and 2008,
and is now a professor at the MIT Sloan School of Management and
a senior fellow at the Peterson Institute for International
Economics, is a Bloomberg View columnist. The opinions expressed
are their own.)